Junk Bond Struggle

{Q} Michael Milken made a fortune in the high-yield market by analyzing default rates on this paper and recognizing that it was vastly underpriced in terms of the imputed risk of the default. Is that still true?

I think we’re going to prove during this [business] cycle that it’s still true. The last time spreads got north of 1,000 basis points, defaults had spiked up higher than 9 percent of the total issued securities in this sector. That was back in 2002, and it was driven by problems in the telecom industry, which had grown to 20–25 percent of the high-yield market. The default rate [of high-yield bonds] without telecom peaked at around 5 percent.

We finished 2007 with a default rate below 1 percent, according to J. P. Morgan. This was the lowest default rate in history. Some are estimating that number to go back up to 4 to 5 percent in 2008. We think that is a bit aggressive. The default rate is definitely trending higher, but it’s not going up quite that rapidly.

{Q} What level of defaults do you think the market is pricing in now?

I’ve seen estimates that current high-yield prices suggest an 8 percent default rate. Maybe we are heading in that direction in 2009 if this economy unfolds into a recession, but it’s certainly not where we think we are going to be in 2008.

{Q} Where are spreads now, and what’s the long-term average spread?

The long-term average is around 540; right now, we are at around 800 basis points. Can we go wider from here? Absolutely. It’s really going to come down to access to capital and liquidity in the market. In 2006 and 2007, when spreads were so narrow, it was because anybody could get money.

{Q} At 800 basis points over Treasuries, shouldn’t we be buying now? What do you tell your average, decently diversified investor?

If people have the right risk tolerance and a diversified portfolio, over the course of a long-term cycle, they’re going to be rewarded. This is a very legitimate asset class and a good way to diversify a portfolio from equities and higher-quality fixed income.

Should you back up the truck and put all your money in the high-yield market? No. But should you start thinking about averaging some dollars into the high-yield market? It seems to make a lot more sense at 800 basis points over Treasuries than it did at 260. Will we continue to have volatility? Absolutely. But now you are earning an attractive yield to compensate for that volatility.